Importance of Real Options in Valuation

Importance of Real Options in Valuation

Almost one in every three IPOs listed in global stock markets are startups/unicorns. Most of these IPOs are not profitable, but their valuations are steep. The argument given for these high valuations is their growth potential, and with growth, these companies would find a path to profitability. From Uber to Lyft to Zomato and Paytm, these are the arguments given by the founders. Yet, when i value the above companies by the conventional DCF, i invariably get a high discount to the price they command. Thus, i got my thinking hat and analyzed if i was missing anything in my valuations or anything that the conventional DCF method could not capture. In this post, i provide insights into the importance of Real Options in Valuation and how adding optionality to your DCF will help you value companies better.

The Option to Expand in Young Companies

In a conventional DCF or relative valuation, we develop financial models on the realistic potential of a startup’s success in terms of revenues and earnings. Thus, the model captures the potential cashflows, and the valuation reflects this upside. However, the assumptions in our model are on how the firms will capture additional market share as the market expands. Still, if the firm expands to other markets, the additional cash flows from the expansion do not get captured. For instance, Apple’s success was initially on the iPod, and if i had valued Apple at that time, my cashflows would rely on the TAM for iPod and Apple’s continued expansion of market share in the iPod market. However, Apple started expanding to the smartphones and wearables segment. Currently, the majority of Apple’s value comes from smartphones. As an investor valuing Apple when it launched iPod, i would not have added cash flows from its smartphone segment and thus would have undervalued Apple. We can expand Apple’s analogy to Microsoft and Facebook, which launched multiple products or expanded their TAM.

Companies have expanded through geographies where success in one market gave companies the confidence to expand to other countries. Mc Donalds, Coke, and KFC are examples of successful brands in the US that expanded to other countries by customizing their menus to suit local cultures.

Now the big question is, what prevents us from adding these cashflows in our conventional DCF. In my view, there are two challenges.

  1. First, our forecasts about these potential product and market expansions will be very unclear at the initial valuation, and the cash flows will reflect this uncertainty. Even the companies like Apple and Microsoft that expanded would not have been able to visualize the potential markets for Microsoft Office or the iPhone when introducing MSDOS or the iPod. 
  2. The second is that Apple and Microsoft would have learned a lot at the launch of iPod or MS Office and would have incorporated those learnings or not repeated the same mistakes when they launched the following products. This learning and adaptive behavior give rise to the option value.

Valuing Real Options to expand in Startups

Let us take the case of Zomato, and when i value Zomato with an assumption that it would continue to be in the food delivery markets, i get the value/share at Rs.35, which is far less than the subscribed price. But, if i value Zomato given its optionality to expand from food delivery markets to other markets, what are the uncertainties that i would face when estimating its value? 

  1. I assume Zomato would move to groceries and compete with Big Basket. I estimate the expected value of Zomato on this premise and factor the cost of going ahead with the expansion option today: I forecast the incremental cash flows coming from this optionality. The only problem that i have is making these estimates, as i dont have enough information on Zomato’s potential competitive advantage in these potential markets, but that is precisely where the option value is derived.
  2. After estimating the incremental cash flows from optionality, we need to estimate this uncertainty from cashflows in the form of a standard deviation in the value of the cash flows. To measure this uncertainty, we can use the public listed companies’ standard deviation or run simulations on the expansion investment and derive a standard deviation in the value of the expected cash flow across simulations.
  3. Ascertain the time when the firm will have to make the expansion choice: There has to be a time when the firm either has to decide to expand or abandon that option. For some companies like pharma or tech companies whose patent or license expires, this optionality can be self-imposed.
  4. Now we have the inputs to value the optionality with the present value of the future cash flows from expansion – the value of the underlying asset, and the cost of expansion today becomes the strike price. The standard deviation in value is the volatility in the underlying assets, and the option’s life is the point in time by which the expansion decision needs to get taken. Binomial option pricing models work better at pricing real options because they allow for early exercise, but the traditional Black Scholes model produces rational approximations for most real options.

Limitations with the Real Options in Valuation

Adding value to any startup with an option to expand has its downside. However, every analyst/founder of a startup can use this optionality to expand to justify their high valuations. Furthermore, this option to expand can apply for companies with a competitive advantage and not for all companies in the market. For example, Microsoft’s exclusivity in developing Office emerged from its control of the operating system; thus, it had a significant advantage over the competition when developing its software. On the other hand, Apple’s exclusivity came from a brand name for innovation and coolness with the iPod. Both were decisive components in the adoption of the iPhone.

In effect, we cannot mistake opportunities for options and use the actual options argument to add premiums to any company with high growth potential. For instance, every tech company in growing markets (EV or alternate energy) or startups in emerging markets (Indian and Chinese companies) can demand a premium for optionality. When we do that, we double count the value of growth, once through the expected cash flows in discounted cash flow valuation, and again when they add the premium. 

Conclusion

While real options are a potent and effective tool for assessing value, markets need to apply them selectively. For example, the option to expand adds value only when the market cannot adequately capture the potential expansion opportunities in the expected cash flows. In addition, companies in question need to have significant competitive advantages over the competition.



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